Section 125 “cafeteria plans” can help lower taxes for both you and your employer. You, as the employee, are permitted to withhold a portion of your pre-tax salary to pay for premium contributions to employer-sponsored insurance plans and to cover qualifying unreimbursed medical and dependent care expenses. Because Section 125 benefits are not subject to FICA or income taxes, cafeteria plans can help lower your taxable income while reducing the payroll and workers’ compensation tax liabilities of your employer.

What’s on the Menu?

As the name suggests, if you participate in a cafeteria plan, you can choose from a menu of employer-sponsored benefits. In some cases, both you and your employer share in benefit costs. Your company’s contribution may consist of an annual benefits allowance that you can use to pay for benefits or take as salary. This system provides flexibility for you as the worker, while helping your employer gain greater control over their benefits expenditures.

The most basic cafeteria plan feature is the premium only plan (POP), sometimes known as premium conversion plans. These plans allow you to withhold part of your pre-tax salary to fund premium contributions to employer-sponsored insurance plans, like medical, dental, disability, accident, and group term life insurance. A POP is easy to set up and administer, and it does not require your employer to offer any new benefits.

The most well-received cafeteria plans are those that include lots of options, such as various life insurance benefits; a choice between traditional medical benefits and an HMO; a dual choice option offering co-insurance for those covered by a spouse’s plan; and employee-funded spending accounts for unreimbursed medical expenses and dependent care expenses, such as child care and elder care.

Flexible Spending Accounts

Flexible spending accounts (FSA) are a popular feature of many cafeteria plans. They provide you with the opportunity to pay for dependent care and/or unreimbursed medical expenses using pre-tax dollars. To take advantage of the FSA option, you must estimate before the start of each tax year how much you will spend on medical or dependent care expenses and commit to having a set amount withheld from each pay period to help cover these expenses. The agreed-upon sum is deducted from your paycheck pretax and deposited in the your FSA. For any qualifying expense, you submit a claim to the plan administrator for reimbursement.

Almost everyone incurs some health care costs that are not covered by insurance. These costs include copays and amounts before the deductible as well as fees for services your plan doesn’t cover like cosmetic surgery, contact lenses, braces for your kids or some prescriptions. Still, for most people, these expenses don’t exceed the 10% adjusted gross income floor that would allow for a federal income tax deduction. By contributing to a medical FSA, you get a tax break on these miscellaneous health care and dental expenses.

The dependent care FSA allows those of you who pay for childcare or eldercare services to save money up front. You don’t have to wait to claim a deduction or credit on your tax returns. Heads of household and married couples are permitted to withhold up to $5,000 annually out of pre-tax earnings to pay for dependent care services that enable them to work, look for work or attend school full time. Qualified dependent care expenses generally include care for a child under the age of 13, as well as in-home or daycare services for a spouse or adult dependent incapable of self-care. Individual employees should, however, calculate whether they and their families would save more by paying for dependent care expenses through an FSA or by claiming the child and dependent care tax credit.

FSAs have a few drawbacks. First, unless an unanticipated change in family status occurs, you can’t change or cancel a Section 125 agreement during the tax year. Second, and most critical, is the “use-it-or-lose-it” deadline imposed by the IRS. This rule stipulates that you forfeit any funds left in your individual FSAs at the end of the year. Your employer keeps the remaining balance to offset administrative costs and to help pay for future benefits.

This rule was modified in 2005 to permit cafeteria plan sponsors to extend the deadline for using the funds for up to 2½ months after the end of the year. There is also a grace period of 90 to 120 days during which employees may submit claims for expenses incurred during the coverage period. But despite additional flexibility, I like HSAs (health savings accounts) more than FSAs since with HSAs you can keep the funds in your account and have them grow tax-free.

Most business owners find that Section 125 cafeteria plans are simple to set up and administer. Because cafeteria plans encourage employees to take an active role in managing their benefits, employers often feel that workers are more aware and appreciative of these plans. But that also means that you, as an employee, have to be smart in learning which options best fit your personal situation.

I would love to hear about your history with cafeteria plans. Does your employer offer one? Let me know via the links below.

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Brian Thompson Financial LLC (“BTF”), is a Registered investment Adviser in the State of Illinois. Based in Chicago, BTF focuses specifically on serving the LGBTQ community locally and nationwide. Brian Thompson, JD, CFP® is a proud member of NAPFA, XY Planning Network and Pride Planners.